Developments in the euro zone are never far from the BOE’s thoughts: not only is the currency area a major export market for the U.K., but London is at the heart of the 18-nation bloc’s financial system, despite the U.K. having chosen to hold on to its own currency and central bank.

The BOE appeared unconvinced that the rapid fall in spreads on bonds issued by governments in what is known as the euro zone’s ‘periphery’–which includes a large number of its members–is warranted and sustainable. It noted that Greece, Italy, Ireland, Portugal and Spain “remain highly indebted,” while their growth prospects are weak.

“The fall in euro-area periphery bond spreads appears to have outpaced improvements in the macroeconomic outlook,” the BOE said, a polite way of saying investors should be demanding higher interest rates to lend to those countries.

The BOE also noted that with inflation in the euro zone at very low levels–0.5% in May–it will be more difficult for governments, households and businesses to lower those high levels of debt. It also said that low inflation makes it more difficult for the euro zone to rebalance, or make economies in the south more competitive relative to those in the north.

Deprived of the ability to devalue their currencies, these troubled euro-zone members have to regain competitiveness by cutting their labor costs–and prices–relative to their economically stronger northern neighbors, a process known as “internal devaluation.” That is more difficult to accomplish when inflation in the euro zone as a whole is low.

In conclusion, the BOE warned investors that prices of euro-zone government bonds might fall if there was wide acknowledgment of how much difficulty the currency area still faces in emerging from its interlinked government debt and banking crises.

“There remains a risk that assets might reprice rapidly if confidence in the authorities’ ability to achieve the rebalancing and adjustments required in the euro area were to deteriorate,” the BOE said.

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